Tax breaks exist for underwater homeowners

About 11 million U.S. homeowners owe more than their homes are worth, according to real estate data firm CoreLogic, and while taxes may not be the first thing they think about in deciding what to do, all the various options have tax consequences.

Until the end of this year, at least, there is a tax break for homeowners who negotiate debt reduction with their lenders.

Some of these “underwater” owners may qualify for principal reduction through the massive mortgage foreclosure settlement announced in February. Others may pursue short sales, in which the home is sold for less than the bank is owed, or wind up in foreclosure.

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But those whose lenders cancel their debt would ordinarily face the tax man, because cancellation of debt, including mortgage reduction, is generally taxable. That means if you get your mortgage reduced by $100,000 and you’re in the 28 percent tax bracket, you’d owe $28,000 in federal taxes on the “income” you received when your debt was forgiven.

Typically, the only way to avoid those taxes is to declare bankruptcy or to claim insolvency, which does not require a bankruptcy filing but still requires that your debts outweigh your assets. Being foreclosed in a state like California, which has “non-recourse” rules that prohibit lenders from coming after you for extra cash after they’ve taken your house, also exempts one from taxes.

A special federal tax break to help ailing homeowners, put in place in 2007, allows them to exclude up to $2 million in forgiven mortgage debt from their income. To qualify, that debt has to be for your primary home – sorry, no vacation homes or investment properties.

With the tax break slated to expire in nine months, if you’re currently sinking under the weight of your home, there’s a reason to move quickly. No one can accurately foresee whether the provision will be renewed by Congress, and dealing with underwater real estate takes time.

“These problems are now winding their way through the final stages, and that’s where the tax part comes up,” says Larry McKoy, a certified public accountant and partner at Dixon Hughes Goodman, in Glen Allen, Virginia.

COMPLICATIONS

Even for this year, while that special tax break is in effect, there are complications. Most important, only the funds that you spent buying or improving your home count. So if you took extra cash out of your house during a refinancing or with a home-equity loan, spent it on vacations or on your kids’ college educations and then ran into trouble, you’re out of luck. If you put part of the money into your home and spent the rest elsewhere, you’ll need to be able to track those amounts.

Another huge issue: Not all states take their cue from the feds, so even with the federal tax break in effect, you might still owe state income taxes on the canceled debt.

Principal reductions are relatively straightforward for tax purposes. You will receive a 1099-C form, for cancellation of debt, from your lender in the tax year the deal is done. Thus if you renegotiated your debt and got your principal reduced in 2011, you should have received this tax form already.

ON THE HOOK

Foreclosures and short sales can get more complex. Although you may think you’ve finished the deal, if you live in a “recourse” state, in which the bank can come after you for the amount you owe beyond what the asset is worth, you may remain on the hook for years after the fact. In 41 states and the District of Columbia, lenders can sue for the balance of the debt long after the house is gone.